Can stocks be safer than bonds?

By Felix Salmon
July 5, 2011

y2kurtus leaves an interesting comment, in the context of a world where major sovereign defaults seem increasingly likely:

A topic of great interest the next few weeks will be what is truly the worlds most investable ultra low risk asset. Curently the market says it’s U.S. T-bills and German Euro Bonds.

I’m on the other side of that trade… put my money into ultra-high quality equities which generate meaningful %’s of their earnings in several currencies and whose dividends (untaxable to me in IRA’s) are higher than the 10 year treasury. Like TFF I’m more worried about the dependability of the cashflows than the day to day volitility of the principal.

What y2kurtus is talking about here is stocks like Johnson & Johnson. Its dividend yield is 3.39% — higher than the 10-year Treasury rate of 3.2%. It’s international, and it has very little leverage: total debt to equity is less than 30%.

Such stocks have one clear advantage over any kind of bonds: they’re much less prone to being eaten away by inflation. If you own a company, then you’re selling things which tend to go up in price in line with inflation. And if you own a diversified group of companies, then your inflation risk is much lower than if you own a set of liabilities which are fixed in dollar terms.

And as y2kurtus notes, if the companies are broadly diversified internationally, their stocks should offer decent protection against a plunging currency, too.

On the other hand, when times get tough, companies not only can but should cut their dividends. Just when you need that income most, it’s prone to disappear.

J&J might be paying out 57 cents per quarter right now, but that dividend has been growing at an impressive rate indeed — it was just 5 cents 20 years ago. With hindsight, buying a stock which was going to see its dividend grow by 12% per year compounded would indeed have been a very good idea. (J&J stock was trading at $7.03, adjusted for splits, 20 years ago; it’s $67.30 today.)

But would you have sold the stock by now, if you’d bought back then? One question that y2kurtus leaves open is whether you should sell stocks if and when their dividend yields drop below the 10-year Treasury. JNJ was certainly there — 10 years ago its dividend yield was just 1.4%, when the 10-year Treasury was yielding 5.4%. (And indeed, over the past 10 years, you would have been better off in long-dated Treasuries than in J&J.)

More generally, if J&J’s dividends can go up enormously over time, they can go down enormously over time as well. Companies fail. And on an individual-company basis, there’s no dividend in the world which is remotely as dependable as the coupons on Treasury securities. Even on a diversified basis, dividends are — and should be — cyclical, going up in good times and down in bad times. Which is the exact opposite of what you’d ideally want from an investment. Dividend cashflows have a nasty habit of being “dependable”, in other words, only up until the point at which you actually want to start depending on them.

Remember BP?

BP and Shell between them account for 50% of the dividends paid by UK companies every year. It seems quaint, but there really are a lot of far-from-wealthy people in the UK who live off their dividend income, and those people constitute a surprisingly large part of BP’s shareholder base. If BP suspends its dividend, the only way they can get money from their stock is by selling it.

These small investors didn’t care about volatility of principal at all, so long as they kept on getting their dividends. But the minute that the dividend disappeared, the volatility of the principal became hugely important. And even if you didn’t need to sell your BP shares when it suspended its dividend, any dividend-stock investor would feel a bit of a chump holding onto shares which weren’t paying a dividend at all.

On top of all that, there are good reasons why companies should not declare large dividends, and should spend the money on stock buybacks instead. Why force all your investors to declare dividend income, when buybacks are an elegant way of returning money to the shareholders who want it, while allowing those who don’t to benefit from a smaller float? So long as capital gains taxes are lower than income taxes, a lot of shareholders will be quietly encouraging companies to go the buyback route rather than the dividend route.

So if you’re looking for the worlds most investable ultra low risk asset, I’m not convinced that a portfolio of high-dividend stocks is necessarily the way to go. It just doesn’t make sense to me that an asset which can lose all its cashflows and half its value overnight could ever be considered “ultra low risk”, no matter how sanguine you are about price volatility. And even though you can diversify, that doesn’t tend to work very well during crises.

Still, there is one good thing about holding stocks as part of a low-risk portfolio: you can’t kid yourself that there’s no risk there at all. Debt is treacherous, and hides its risks; with stocks, the risks are out there in the open for all to see. Nothing would be better for reducing the amount of systemic tail risk in the economy than seeing a large number of people coming around to the idea that stocks are safer than bonds. So I applaud y2kurtus for his asset allocation. And maybe, if we see some catastrophic bond defaults, others will follow suit. And we’ll see the kind of painful yet necessary deleveraging which we needed after the financial crisis but failed to get.

9 comments

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What are you recommending? 100% invested in 10-year Treasuries? To trash y2kurtus’s thesis as if the choice is binary is at best incomplete on your part. I doubt y2kurtus would put 100% of his funds in one stock. If you had $1 million dollars in your retirement account and were 60 years old, what would be your allocation? Your age in bonds, 30% in stocks and 10% cash? How many stocks would be part of that 30% or would you buy an index? And where would you put your cash? In US bank money funds that buy commercial paper in European banks that are exposed to Greece? If not in such money funds, then where would you cash go? It is a lot harder to say what you would actually do than just trash the thesis of y2kurtus. Do you care to step up with advice or do you just want to remain a critic of others?

Posted by tgriffin | Report as abusive

Given the structure of the company, in the traditional sense, J&J debt is safer and wont reduce during recession. In fact if you talk about preferred equity then that satisfies your complaints about payout ratios and still allows upside participation and inflation hedging.

Posted by Shadeun | Report as abusive

Comparing the dividends of BP and JNJ are apples to oranges. One company has raised their dividends for 48 years in a row; another paid a lower dividend as early as 2002 (based on the dividend data from BP’s website).

It would be interesting to compare the change in yield from the S&P Dividend Aristocrats over time with that of the 10 year treasury.

Posted by djiddish98 | Report as abusive

@tgriffin,

I don’t read Felix’s post as trashing my “advice” at all. Felix is never going to offer an alternitive financial plan because he has always structured his blog blog as a clearinghouse of ideas.

The thrust of my comment (which I don’t intend as advice) is that if you want to buy assets that guarentee a nominal dollar amount IE $1000/month than buy bonds and don’t stop working until you’ve got the dough to survive todays low rates.

If you want to insure that you can eat well, pay the light bill, put gas in your tank, and perhaps even uncork a few bottles of decent wine in year 15 of an active retirement; well then the 1 day liquidity and low volitility of a treasury bond portfolio don’t protect you from inflation/currency devaluation which I will argue are probably your largest risks at this point.

I would happily invest in well managed equities that paid out a fixed % of earnings rather than a fixed amount /share. Also over half of my investments pay no dividends at all. My current plan is to work until death and leave as much as possible to my family, library, and land trust.

A day will almost surely come when I’ll need to draw from my portfolio, but I don’t distinguish between capital gains and dividend income the way the IRS does.

Posted by y2kurtus | Report as abusive

Noone mentions that for a lot of folks, Social Security is a big part of their retirement income. For those folks, they are already heavily overweighted in US Treasuries. Any additional dollar they put into bonds just puts them even more over the top. Inflation isn’t in the picture when you are that top heavy from the gitgo. And that’s without any thought to the other gorilla in waiting, just the simple fact that dollar denominated public debt is the biggest bubble in all of history, by far. This time, this bubble will be the Grand Finale.

Posted by threeRivers | Report as abusive

A major item not considered here is the structural difference between a well run company and a Government.

A well run company will be run by people whose primary interests are aligned with the shareholders. If the company prospers, both management and shareholders prosper, as well as employees. A Government such as the one in the USA is devoted to transferring wealth from the least powerful in the country to the most powerful. With a corrupted election procedure, there is no check on their ability to print money and raise regressive taxes such as FICA. They cannot lose an election because only their candidates are permitted to run and they control the courts.

So, if you think politicians are good people who really have your best interests at heart, buy Treasuries. If you examine the record and check out the tiny differences between our political parties, buy either JNJ or BP.

Posted by txgadfly | Report as abusive

Recommending the purchase of JNJ when we are only halfway through a the biggest bear market in equities since the 1970′s? Well it just shows how difficult it can be to kill the bull. Don’t be in any hurry to buy eqities!

In the words of Jesse Livermore:
“Throughout all my years of investing I’ve found that the big money was never made in the buying or the selling. The big money was made in the waiting.”

Posted by ezam1 | Report as abusive

Thanks for the mention, y2kurtus…

Our allocation is roughly 75% stocks (split between 12-15 different multinationals, based both in the US and elsewhere), 25% fixed-value (annuity, TIPS, bonds, and cash holdings). I see the stock allocation as the more promising segment of the portfolio, but am sufficiently comfortable that we don’t need to take the risk of a more aggressive allocation.

Splitting the stock allocation between ~15 different companies minimizes the “Enron risk”. It is theoretically possible that JNJ will experience some massive disaster and will be forced to cut its dividend, however a complete wipeout would cost us just ~5% of our assets. This is an acceptable level of risk for us.

Finally, would like to strongly second this sentiment: “Debt is treacherous, and hides its risks; with stocks, the risks are out there in the open for all to see.”

Suppose I were to invest 40% of our assets in ten-year bonds? Suppose we were to then see double-digit inflation for seven years? On a real-value basis, approximately 20% of our assets would be wiped out. Irrecoverably wiped out (barring deflation), not a temporary dip like the 2008-9 market crash. That is the equivalent of having FOUR of our fifteen blue-chip issues getting wiped out.

The correlation between investment-grade bond returns is very tight, since they depend primarily on currency and macroeconomic climate. Putting 40% of your money into dollar-denominated bonds (even if split between Treasury and corporate) is almost as risky as putting 40% of your money into a single stock. And no sane advisor would EVER recommend that!

Posted by TFF | Report as abusive

“Don’t be in any hurry to buy equities!”

I’m not. I’ve been selling over the past year. (Very substantial selling, amounting to some 20% of our net worth.) But I’ve got a hundred grand ready to buy again if/when the bear returns.

Posted by TFF | Report as abusive